Outlook 2016 – Business Cycle (UK Equities)

Capital returns will be harder to sustain and therefore income such as dividends and special returns of capital will become an even more important factor in overall returns

A preference for growth over value will likely remain an important theme going into 2016 and domestic consumer-focused companies could maintain their run of outperformance

UK base rates remain low, and any tightening is probably going to be gradual, and so unlikely to derail the British economic recovery.

China pressure

Investors have endured a volatile ride in 2015 as the economic slowdown in China and emerging markets more generally has weighed on global activity.

Despite aggressive monetary easing, European growth has also disappointed some of the more bullish expectations and while US GDP growth has been more robust, activity has faded recently as the oil industry has contracted due to the fall in the oil price.

Despite this, some areas of the FTSE All-Share have enjoyed strong relative returns in particular domestically-facing sectors (for example consumer cyclicals such as house builders) as they have been seen by investors as beneficiaries of a robust UK economy, low interest rates and falling commodity prices.

After a more turbulent year for markets and the global economy in 2015, to us it seems clear that the business cycle has shifted to the slowdown phase.

However, other sectors, especially those exposed to global trends (such as commodities or Asian Financials) have been under pressure in 2015 and have underperformed materially, with large-cap UK listed oil and mining companies the most obvious examples.

Market confidence was undermined in the summer by a combination of the devaluation, albeit small, of the Chinese currency and the prospect of rising interest rates in the US.

Together these developments suggest that the status quo of ultra-loose monetary policy in the US and a pegged currency in China is coming to an end.

In this respect, the underlying economy in China is perhaps less resilient to an appreciating renminbi than previously thought and is going through a period of profound structural change.

Slowdown not showdown?

Given this context, we are compelled to ask whether investors face showdown or slowdown in 2016.

In our view 2016 is more likely to represent a slowdown phase in the business cycle, a period in which equities overall should still generate positive returns, although with wider dispersion and more volatility, a trend already well established.

In addition, capital returns will be harder to sustain and therefore income such as dividends and special returns of capital will become an even more important factor in overall returns for equity investors. We will return to the subject of UK dividends more specifically later on.

Our contention was always that this would be an extended business cycle.

It is extended because aggressive monetary policy measures used to stave off a deeper recession in 2008 have been prolonged, helping to offset some of the downside, but in so doing, these policy measures have prolonged the life of unproductive capital and this has meant that nominal growth rates have been substantially below those seen in previous credit-driven cycles.

Commodity collapse

Meanwhile, governments have retrenched and remained fiscally tighter, thereby constraining investment and growth. This cycle is already long in the tooth and showing increasing signs of tiredness.

One of the more obvious aspects of the cycle’s maturity has been the collapse in commodity prices as the Chinese economic “miracle” has run into problems. Investors have clearly recognised this factor in their negative view on commodity related sectors such as mining and oils which have experienced substantial falls year to date.

The decline in commodity prices also undermines a much wider part of equity markets’ earnings base.

Investors will need to be particularly vigilant about balance sheet strength going in 2016, especially if a tightening rate cycle precipitates a further widening in credit spreads.

In general, rising commodity prices support corporate pricing power especially in the industrial sector of the market, be it direct beneficiaries of the commodity boom (such as mining suppliers) or indirect users of those commodities (such as chemicals).

At the same time wage inflation is starting to accelerate in both the UK and US, putting further pressure on corporate margins and profitability.

With the loss of “air cover” from rising input prices to raise headline prices, the outlook for corporate pricing power and profitability has already deteriorated.

Rising interest rates

It seems likely that the Federal Reserve will start to raise interest rates in 2016 as a result of an improving labour market where wages are going up.

Normally the start of a rate tightening cycle coincides with corporate profit margins expanding as demand recovers and companies benefit from operational borrowing.

However, this time we feel that margins are already at elevated levels, particularly in the industrial areas and the rising cost of finance will put further pressure on earnings and capital investment.

In essence a rising rate cycle may well coincide with a peak in margins this time. It looks to us that the period of peak earnings on a global basis are behind us and while year-on-year growth in earnings should remain positive, the rate of growth is falling.

As usual, the US looks to be leading the global business/earnings cycle with Europe someway behind, though potentially enjoying a much-awaited later cycle recovery. The UK seems to be somewhere in the middle.

Ready for lift off?

A key concern for investors has been the trajectory of inflation generally and wage inflation specifically.

While headline inflation in 2015 has been very low, core inflation (excluding energy and food) in the US and the UK has been more resilient.

A failure to raise interest rates in September looks unlikely to be repeated in December 2015 after some very strong labour market data.

Focus from doves on the Federal Open Market Committee seems to have shifted to the trajectory of interest rates rather than the timing of ‘lift-off’.

Credit spreads1 have already started to widen and financing for corporates, particularly those with stretched balance sheets, will get more difficult.

Offsetting this, the economy is sustaining high employment levels, while a tightening labour market is set to drive real wages higher. Consumption is the strongest driver of real end demand, meaning this should serve to dispel deflation fears.

Value opportunities

For equity markets these conditions are likely to result in a preference for growth over value remaining an important theme going into 2016. We also expect the domestic consumer-focused companies to maintain their run of outperformance.

UK base rates remain low, and any tightening is probably going to be gradual, and so unlikely to derail the British economic recovery.

End demand in developed economies is robust, unemployment rates are low and falling and wage inflation is accelerating.

A return of some inflation, while concerning for central bankers, would be helpful for total demand and we still see opportunities for selected corporates to make good returns. In addition, recent market volatility has opened up a number of shorter-term value opportunities.

However, it is prudent to continue to tilt portfolios to a defensive skew – with key areas for the portfolio in Growth Defensives and Value Defensives (see graphic below) on a selective basis.

Our portfolios

While our overall tilt in portfolios is towards a more defensive and/or stable income skew we have maintained some higher-beta2 exposure in the form of Consumer Cyclicals and Financials, in order to benefit from the ongoing recovery in domestic demand.

After a more turbulent year for markets and the global economy in 2015, to us it seems clear that the business cycle has shifted to the slowdown phase.

Rising wage inflation, interest rates and peaking corporate margins are all hallmarks of this phase of the cycle.

GDP growth will remain positive with developed markets more robust than developing markets. However, credit spreads while still at historically low levels, have already started to widen and not just in the more obviously troubled sectors e.g. oil, mining and related industrials, but also in previously more resilient areas.

This, to our minds, is confirmation that the slowdown phase has begun. There are still good returns to be made from equities, but a more defensive skew is prudent.

Dividend dynamos

One of the brighter spots for the UK may be dividends, although we anticipate pressure on the UK market’s total aggregate cash dividend.

There were two notable disappointments in 2015, with British Gas owner Centrica and mining group Glencore both reducing their dividend payments, and we expect more disappointments to come.

In light of these potential risks, investors will need to be particularly vigilant about balance sheet strength going in 2016, especially if a tightening rate cycle precipitates a further widening in credit spreads.

There are still a good number of companies in the UK market that are able to sustain dividend growth of 5-6% over the next few years, in line with the long-term nominal rate of UK market dividend growth.

In a low growth, low inflation environment, dividends and dividend growth in particular should still offer attractive returns for investors in the face of potential capital losses from bonds.

1. The difference in yield between government bonds and corporate bonds.↩

2. Beta measures the average extent to which a share moves relative to the broader market. The beta of a market is 1. A share with a beta of more than 1 moves on average to a greater extent than the market. A share with a beta of less than 1 moves on average to a lesser extent.↩

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UK equities look attractively valued as an asset class and we believe that a backdrop of moderate growth, low interest rates and subdued inflation should allow further upward progress to be made in the year ahead.

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